SMSFs and insurance: death and permanent disability cover

One of the recommendations of the Cooper Review of the superannuation system, accepted by the government, will require self-managed superannuation funds (SMSFs) to consider death and permanent disability insurance as part of the fund's investment strategy.

The main reason for the recommendation is the alarmingly low level of life insurance inside SMSFs. Less than 13 per cent of SMSF members have life insurance.

This is significantly less than the levels of cover within traditional superannuation funds, where cover is often provided automatically.

Under current laws, SMSF trustees are not required to obtain any insurance cover for members, nor do they need to consider insurance as part of the fund's investment strategy.

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The proposal is that the Government will amend the superannuation law so that SMSF trustees must consider life and total and permanent disablement (TPD) insurance.

Although there is no commencement date for the proposal, SMSF trustees should review their investment strategy with regards to insurance in readiness for any change.

This can be considered as part of the member's financial planning strategy, in association with any other current insurance they may have inside and outside superannuation.

Insurance cover taken out by the trustees of an SMSF can provide a valuable source of liquidity and the ability to pay increased benefits to fund members or their beneficiaries in the event of a member's death or disability.

Another instance may allow an SMSF that has borrowed under a limited recourse borrowing arrangement to repay part or the entire loan in the case of the death or permanent disability of a member.

Case study

Noel and Nancy have $200,000 each in their SMSF. They use the $400,000 as equity to borrow $600,000 for $1million property.

In the event of Noel's death, a $200,000 benefit must be paid (as a lump sum or pension), but the SMSF has no other assets. The property may need to be sold, which could be at a low point in the market.

Furthermore, transaction costs may be incurred in repaying the loan early. In effect, the investment strategy of building long-term wealth for the members has fallen into disrepair as no insurance has been taken out as a protection measure.

With prudent planning we can secure the outcome. Let's assume in the event of death, the objective is to repay the SMSF borrowing and pay a net lump sum death benefit of $1million.

The SMSF purchases a $1.6million policy on each life. In event of death, the $600,000 SMSF borrowing is repaid and a $1million cash benefit can be paid (including $200,000 member balance).

The property can be retained as no forced sale is required. Including insurance as part of the fund's investment strategy has allowed Noel and Nancy to achieve their objectives.

How is the insurance cover established?

 Insurance held via an SMSF is owned by the trustee of the superannuation fund (ie, it is not owned personally). 

 When applying for cover, it is important to ensure the owner is clearly identified as the trustee, for example 'John and Jane as trustees for the JJ super fund' or 'JJ Co. Pty Ltd as trustee for the JJ super fund'.

 All SMSF assets, including insurance, must be kept separate from personal or business assets.

 Insurance premiums can be paid using the fund's cash balance or superannuation contributions/ rollovers.

What are the tax concessions?

While the focus should always be on the need for insurance, cover within an SMSF can provide valuable tax concessions.

For one, the SMSF trustee can generally claim a tax deduction on the insurance premium, excluding trauma cover.

In addition, superannuation contribution strategies (eg, salary sacrifice) can reduce the effective cost of cover by using pre-tax dollars.

Other strategies available include personal deductible contributions, co-contributions, spouse contribution tax offsets, and contribution splitting.

How can proceeds be accessed?

Upon successful claim, the insurance proceeds are received by the SMSF trustee. A payment can only be made to a member, beneficiary or the member's estate if a condition of release is met.

A condition of release includes temporary disability, permanent disability or the death of the member.

The SMSF trustee is bound to make a decision as to whether a member meets a condition of release, just like all other fund trustees.

This requires the SMSF trustees to apply an appropriate level of due diligence, and ensure appropriate documentation is retained.

If a condition of release is met and the rules of the fund allow, the benefit may be paid from the SMSF in the form of a lump sum or income stream.

An income stream can be a very tax-effective option, particularly for eligible dependants, and it allows funds to remain within the SMSF environment.

Can a policy be transferred into an SMSF?

An SMSF cannot acquire an insurance policy from a member, or a relative of a member.

However, a policy can be terminated and a new policy issued on similar terms to be owned by the SMSF, provided there are no underwriting issues.

For some clients, having some or all of their insurance cover within their SMSF can provide valuable cash flow and tax advantages.

It should be borne in mind that using SMSF assets to purchase insurance may have the effect of reducing their account balances over time. 

Insurance proceeds are able to increase the amount available to a member, dependants or their estate should something happen to them.

They can also be used to maximise the tax-effectiveness of insurance benefits, as the superannuation fund has access to special tax deductions for premiums which are not available personally.

Cameron Peck is the managing director of Self Secure Life.